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OUTSOURCING TO CHINA
Transportation and Infrastructure ChallengesDuring Outsourcing Operations to China
Date: 10/15/2009Bhavin Gandhi
Morrison University
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Abstract
Lots of senior executives at multinational corporations (MNCs) all over the world are focusing
more of their time and their companies resources on countries like India and China. In years to
come, MNCs will face new challenges in their China operations: nurturing the growing number
of more educated and experienced Chinese managers and leveraging their China operations in
a way that contributes to their global competitive advantage.
Twenty years ago it was widely believed that companies that wanted to source products from
China were best off focusing on simple, labor-intensive products such as shoes, toys and clothes.
Today, however, high-tech companies such as Dell, IBM, Philips, Samsung and Nokia are
turning to China to source parts and products that demand sophisticated technology and
considerable R&D. With increase in complexity of business, challenges in Chinas operations
are also increasing. This paper will focus on infrastructure challenges that a company might
face during its operations in China.
A decade ago multinational firms operating in China had to carry higher levels of inventory
than comparable firms in the U.S. or Western Europe because the logistical challenge of moving
goods around the country was enormous. Today, while matters have improved, gaps still persist
in China as transportation capabilities lag behind the hectic pace set by the manufacturing
sector.
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This paper will elaborate on both of these issues. This paper will explain some basic problems
in establishing an outsourcing center in China. And this paper will emphasis on existing
transportation challenges in China.
OUTSOURCING TO CHINA
As economy evolves in China with growing larger, more complex and more competitive
business operations; senior executives at multinational corporations (MNCs) in the U.S, Europe
and Asia are focusing more of their time and their companies resources on China. In years to
come, MNCs will face new challenges in their China operations: nurturing the growing number
of more educated and experienced Chinese managers and leveraging their China operations in a
way that contributes to their global competitive advantage().
In past years, the typical general manager in China was assigned the relatively
straightforward task of either selling his multinationals products in that country or helping the
parent firm establish operations to leverage Chinas strength as a low-cost producer. But the
demand in China managers has become more multifaceted now days. Government or MNCs
have either addressed or resolved some of the issues of outsourcing in China; but managers in
China still have to address significant growth in demand in China and all of the challenges
inherent in competing against foreign and domestic companies in what is already a vast, difficult
market.
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1.1. Cost Challenges in China
Chinas advantage over western suppliers does not just stem from low labor costs. Other
necessities for business like land, buildings and machinery are less expensive, too. Everything is
cheaper in China. If you set up a metal processing plant or textile plant, the investment required
is a lot lower than for equivalent facilities in other developed countries like U.S. or European
Union, anywhere from 20% to 80% less. And if you use local machinery say, a metal-
stamping press made in China your supplier passes on his cost advantage. It is 30% to 40%
cheaper than what you might get from a U.S. or Japanese manufacturer. Constructing an
aluminum smelter, which could cost $1 billion to $2 billion in the U.S, costs half that in China().
Due to lower wages, companies can deploy workers where, in the West, they might have
opted for machines. For example, take packaging - which in the U.S. and Europe is typically
done mechanically. In China, one might go back to a formula from the 60s of buying some basic
equipment and have 30 or 40 people wrapping by hand. In fact, that would be the cheapest way
in China instead of importing/buying those costlier packaging machines. This factor can create
challenging situations for international managers, forcing them to relearn labor-intensive
production techniques that are already obsolete in the West, but which are necessary to keep
costs competitive in China().
MNCs must understand that, though they will eventually save money in the long run by
outsourcing their operations to China, they can face big startup costs as they begin sourcing in
China. International Game Technology (IGT), largest manufacturer of slot machines for
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gambling machines, took more than 2 years to establish their R&D Department in China. IGT
had to bring their senior people and put them on the ground of China for more than 3-4 months
to just establish their Product Assurance (PA) department in China. Establishing their PA
Department in China, it cost them 20% more than their expected budget. Hence, putting this
experience in to simple words, one would rather say that until one's engineering, manufacturing
and purchasing folks have been to China, it is hard to even estimate startup cost of opening an
outsourcing center in China.
1.2. Struggle in Electricity
Sourcing from China also means exposing a companys supply chain to disruptions that
are uncommon in the U.S. and Europe. Electricity is a huge problem in China right now. One
can have chronic shortages(). Hence in crunch time, it is not certain that your outsourcing center
is going to have power. So things may not run as smoothly in China as compared to U.S. or
Europe.
Chinas economy has grown faster than its electrical grid and generation capacity, so
demand for electricity has outstripped supply. The government is working to bring more
generation capacity online, and the problem should be resolved within a few years(). Until then,
foreign multinationals should investigate the local energy situation before opening their
outsourcing center in China. The other solution to this problem can be - supplemental
generators. But before they go with this route, they have to estimate the cost of electricity used
through generators over period of 5-10 years, which is very hard to estimate.
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1.3. Copyrights Issues in China
Another risk while opening an outsourcing center in China is lack of enforcement of laws
protecting intellectual property(). One can simply put "copying is rampant in China". And while
a copycat probably would be unable to export knockoff products, such goods could be sold into
the Chinese domestic market, which is huge and growing. MNCs, therefore, need to be careful
about which technologies they share with their Chinese center. If a technology is especially
crucial to a companys mission, it might best be kept in-house, even if production occurs in
China.
Chinas record in the area of protecting one's intellectual property has been poor, and
companies contemplating setting up R&D facilities have been leery about reaping short-term
gains but long term losses, as they, in effect, train their own competitors to innovate in ways that
are quickly used against them().
The idea that China, as its own companies continue to grow and innovate, will rapidly
develop its own interest in enforcing patent law is one reason to be hopeful. But till then
companies should be more precautious regarding their intellectual properties, if they have their
outsourcing center in China.
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1.4. Communication Challenges in China
Ones biggest challenge in doing business in China is communication. It is hard to do
quality communication with Chinese people. Most Westerners think that most Chinese speak
English well. That is a big misunderstanding. The person who works in overseas marketing
does, but the engineers and quality control people don't. Most of the Westerners make their
presentations, unaware that they are not being understood 100 percent.
As you might know, Asians say "Yes" to almost everything. But the "Yes" can mean a
hundred things other than what we mean by "Yes" in the West. This phenomenon can invite
major problems. Also in the West, one likes to hear from his/her supplier every four hours when
there is a problem. They want their questions answered at once: What are you doing to solve
the problem?, When is it going to be fixed? etc. Most of North American and European
suppliers respond quickly. If they don't have the answer, they'll call or e-mail to let you know
that they are working on it. Typically, Asian suppliers will not do the same. If they don't have
the answer, you won't hear from them. They will avoid the conversation and are unlikely to even
send an e-mail confirming that they received your enquiry. Is this an avoidance tactic? Usually,
it's not. Asians do not like to respond until they have a complete answer. That would mean loss
of face. They think, "How will you be able to trust me in the future if I give you an inaccurate
response now?"().
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Challenges like these can create major problems while working with/in China. To
overcome few communication challenges one need to take following things in to
consideration().
Do all the people in your firm who interact with your Chinese center know how to
communicate clearly with Asians?
Do they know how to avoid getting the answer "Yes" to every question?
Do they know the right questions to ask to elicit the required information?
Hire quality managers who are technically skilled and who can communicate well in
Asian language.
Set the expectation with China resources so that, if a problem occurs, they should let you
know right away, and that it's okay to respond without full details.
2. Transportation Challenges in China
Executives at Germanys auto companies were flustered. They knew that China is among
the worlds fastest growing markets for vehicles likely in a few years to overtake Japan as the
second largest after the U.S. Their efforts to tap its potential, however, were being constantly
stymied by factors such as variations in regional tariffs among the countrys 27 provinces and
the inability of local suppliers to meet quality standards for components. In the spring of 2004,
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Volkswagen, Audi, DaimlerChrysler and BMW chose to take matters into their own hands.
Recognizing that these problems were too massive to tackle individually, the companies formed
a joint logistics partnership called Coreteam to deal with logistics and supply chain issues. As
a BMW executive told a reporter, though the German automakers competed with one another, it
also made sense for them to collaborate and exploit synergies when they could().
The experience of the German auto companies serves as a metaphor for the logistics
challenge that confronts global organizations seeking to do business in and with China. One can
agree that Chinas logistics sectors are much greater than they were in the past. Chinese shippers
are maturing, and big western firms such as UPS and DHL have begun to ramp up their
activities in China. Western entrepreneurs also have jumped in to fill gaps between the
manufacturing and retail sectors. Even so, Chinas booming economy continues to outstrip the
growth of its logistics capabilities. China is growing so fast that, in some regions, it is straining
the capacity of its roads, railways and ports and testing the limits of its still young shipping
companies(). The bottom line implication: As companies draw up operations plans for China,
they need to place much greater emphasis on logistics than they might in a developed country.
The efficient distribution of goods and finished products is one of the biggest challenges
associated with Chinas rapid growth. Greater strain has been placed on its transportation,
storage and distribution networks().
The growth of the logistic sector has been fuelled by rising demand for products and
services. Chinas spending on logistics reached RMB 3.8 trillion in 2006 (USD 506 billion),
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having grown by 13.5 percent over the previous year. Market grew by a further 11 percent in
2007 to reach RMB 4.23 trillion().
Transportation accounts for the largest component of total logistics costs, with around 55
percent (RMB 2.1 trillion), followed by inventory storage costs (RMB 1.2 trillion) and
management costs (RMB 500 billion). These logistics numbers may be large, but they reveal one
of the key problems with the sector. As a percentage of GDP, logistics costs are over 18 percent,
and have been around this level since 2001. This is high as compared to other developed
countries, where logistics costs are typically below 10 percent of GDP. This high figure suggests
some operational inefficiency exist throughout the market(). Now let us examine each
component in Chinas transportation system.
2.1. Air freight
Although Chinas airfreight sector is constrained by inadequate infrastructure, its
development has been rapid. TI (U.K. -based research firm Transport Intelligence) projects
annual growth of 10 to 15 percent (assuming that road and rail remain substandard), with much
higher growth rates for services catering to high-value products such as electronics and
pharmaceuticals().
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China also boasts the second-largest domestic airfreight market in the world after the
United States. According to Boeings World Air Cargo Forecast, the market has grown at more
than 20 percent annually since 1991().
Airports are seeing rapid expansion in three principal economic areas: the Yangtze River
Delta (YRD), the Pearl River Delta (PRD), and the capital city of Beijing. Expansion in the PRD
is so significant that it threatens to cut into the volumes handled by Hong Kong, the worlds
largest air cargo airport.
2.2. Express package
Chinas express parcel industry is creating a new history for China. With 40 percent
growth compounded annually, Chinas express parcel industry has broken all the records. Now
permitted to buy domestic companies outright, growth in this industry is going to increase
beyond anyones imagination. UPS already acquired the rest of its venture with Sinotrans while
FedEx bought its joint venture from DTW. Arrival of foreign players has stirred up domestic
competitionfor better and for worse().
2.3. Logistics outsourcing
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The big change in logistic outsourcing is the widespread recognition of the capabilities of
Chinas homegrown companies for domestic logistics work. According to TIs survey of
logistics in China, most of the western manufacturers and retailers are willing to look at Chinese
firms instead of multinational providers.
Most of Chinas third party logistics providers (3PL) are clustered in the three main
economic regions. The sector remains heavily dominated by state-owned enterprises (SOEs)
such as COSCO and Sinotrans. Large SOEs will seek partnerships with foreign-owned
companies, but privately held operators, with their reputations for agility, flexibility and
entrepreneurial capabilities, are more likely to become acquisition targets().
2.4. Rail
Rail was the main form of transportation under the old communist model, but it has not
adapted to the new Chinese economy, says TI. It is primarily geared to moving bulk
commodities long distances. In theory, it should also have strong capability to move containers
from ports to inland cities. But it is a gross understatement to say that Chinas railroads have a
chronic lack of capacity; they would need to double capacity just to cope with current demand.
Chinas government has planned to make major investments in their rail infrastructure
according to their next five-year plan. According to China Logistics 2006, the Chinese
governments long-term objective is to expand the network to around 100,000 kilometers, three
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times the current rate of track-laying, during the next five year(). The quality of infrastructure
will also have to be improved; only 30 percent of the system is electrified today.
Privatization may help for this initiative. Government of China can establish joint
ventures with companies like Sinotrans and COSCO, and develop more sophisticated
infrastructure for rail system in China.
2.5. Roads
Until the late '90s, much of China had rudimentary road system. The best network was
concentrated around coastal cities, and even there roads were variable in quality. From 2004,
there has been vast investment in road building, but the bias toward the eastern coastal cities has
increased().
The many internal barriers imposed by local governments, a situation that magnifies the
economic isolation of one region from each other, also limit development of road services in
China. Internal customs and policing barriers often favor certain transport activities and
organizations.
Since 1996, about two-thirds of government expenditure on infrastructure has been
invested in the road network. The program is scheduled to last until 2015, when the network
should reach about 35,000 km of toll highways(). Private-sector participation is being
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increasingly sought for road construction. But the needs will continue to outpace the road
networks capacity for years.
2.6. Bureaucracy
The Chinese transportation and logistics market is one of the most highly regulated in the
world, according to TI. However, it is slowly opening up to outside competition, and this
process has been facilitated by Chinas 2001 accession to the World Trade Organization.
TI notes that in addition to the regulations that control foreign access to the Chinese
market, there are other controls that constrain both foreign and domestic operators. For example,
the number of freight trucks is controlled through a permit system. Local or regional authorities
award permits, and restrictions are imposed on carriers from outside of the region. In addition,
there are myriad regulatory bodies, including Chinas Ministry of Communications, the Ministry
of Foreign Trade, and the China State Post Bureau. Thus, getting the green light for any logistics
project in China still relies heavily on the strength of contacts within Chinas bureaucracy().
There is much more to Chinas fast-paced logistics story. This is just one angle of the
story. But for all its challenges, the China story is one that more and more U.S. and European
managers are finding that they simply cannot ignore. Of course MNCs like Wipro, TCS and
Infosys, which provides I.T. related services, would hardly have any effect on its operations by
transpiration barrier in their China; due to their core nature of the business. But MNCs who want
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to establish their manufacturing plant in China should analyze the existing condition of
transportation channels before thinking of opening their manufacturing plant in China.
Of course, there is much more to Chinas fast-paced logistics story. But for all its
challenges, the China story is one that more and more U.S. and European managers are finding
that they simply cannot ignore. No doubt there will be other trade and political delegations to
petition for concessions on exchange rates or greenhouse-gas controls. But as long as there is a
Yuan to be made, the trucks will keep rolling, however slowly and inefficiently, all across
China.
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Bhavin Gandhi | Morrison University, Reno, NV